Credit-rating agencies return to crosshairs

WASHINGTON (MarketWatch) -- It's tough to be a credit-rating agency these days. And it may just get tougher.

Under fire for underestimating the danger of bonds backed by subprime mortgages, big companies like Moody's, Fitch and Standard & Poor's have weathered congressional scrutiny of their industry, seen a law passed in 2006 that clarifies how they're officially recognized by regulators and are now the subject of a Securities and Exchange Commission probe into whether they followed proper procedures for rating mortgage-backed securities. See earlier story.

And if that wasn't enough, observers are debating how much further the ratings-industry needs to be changed.

Add it up and it's looking increasingly like the folks who pass judgment on debt and securities are awaiting some kind of judgment themselves.

The verdict for now, though? Uncertain. What is certain is that few appear to be satisfied with the way things are going.

He was answering a question posed at a recent event at the American Enterprise Institute titled "Is the rating agency system broken or fine?"

Having to ask the question in the first place probably means it's at least shaky if not broken. What to do about it is more difficult, but there is no shortage of ideas.

Bass and others say the companies should get rid of the "issuer-pays" system, for one thing. It strikes many as a big conflict of interest that Moody's
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and others are paid by the companies they rate. But the companies argue the current system saves investors money.

"What we feel is important is the steps you take to mitigate any potential conflicts of interest," says Anthony Mirenda, director of corporate communications at Moody's. He says the company uses a number of safeguards including assigning ratings by committee. Analysts also aren't involved in fee discussions with issuers, he says.

Vickie Tillman, executive vice president of Standard & Poor's Credit Market Services, told a Senate panel in September that without payment for ratings by companies, the public ratings issued would be subscription-based instead of free of charge to investors. Standard & Poor's is a unit of the McGraw-Hill Cos.
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Moreover, S&P says it's tightening its criteria and boosting the frequency of its reviews as well as modifying analytical models. It's also doing a survey of originators and their practices concerning data integrity, says a company spokesperson.

Alex Pollock of AEI has another idea: let those who buy decide.

"Why couldn't a group of major institutional investors set up their own rating agency?" Pollock asked the other day. Under Pollock's proposal, the agency would be capitalized by and paid for by the investors and work from their point of view.

Ask Frank Raiter of Luminent Mortgage Capital and Clayton Holdings and he'll say the answer is having ratings agencies update their models at least once a year, use the same loan level data and publish their surveillance criteria. Raiter agreed that S&P, Moody's and the like are "severely disconnected," if not broken, but stressed that the blame for the subprime fallout has to be shared with issuers and investors. Read more subprime coverage.

Those same issuers and investors, of course, are going to keep relying on the agencies for what Pollock characterizes as opinions about the future.

And, as The Wall Street Journal reported earlier this month, some banks and hedge funds rely on credit ratings even when they know the ratings could be flawed, because many mortgage instruments are so difficult to value. On Nov. 9, The Journal reported that the ratings agencies looked poised over the next few weeks to downgrade hundreds of mortgage-related investments worth tens of billions of dollars, creating the potential for more market unrest.

Investors and credit-raters still need each other. But with casualties mounting in Wall Street CEO suites over unexpected losses and the SEC still investigating the industry, expect lawmakers and regulators to keep trying to get the credit-raters into the repair shop.

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